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In general, default is caused by the firm's inability to meet its debt obligations in a timely fashion. At the time of default, however, firms tend to have large outstanding debt. The management of a firm with high default risk is likely to issue more long-term debt to meet its payment obligations in an attempt to gain time.
Therefore, by analyzing the behavior of a firm's long-term debt, we hope to be able to explore its impact on the risk of default. We posit that the default risk is an increasing function of the size of the debt. Our argument rests on the belief that a firm is likely to finance risky projects by issuing new debt as opposed to equity. For low-risk projects with a high net present value, the management of a firm acting in the shareholders' best interest would want to reap the entire expected profits and not share them with new shareholders if equity financing is adopted. By issuing bonds, shareholders promise a fixed payment to bondholders and guarantee to themselves the total profit of the project.

Therefore, a rise in the firm's debt over time may be interpreted as the beginning of more risky investments to follow, and consequently, a larger overall risk of default. Because a company would tap the capital market and raise funds long before the results of its projects become known, the firm's current debt may not capture the entire effect. Instead, we compute the standard deviation of long-term debt levels during the two-year period prior to default. Since the amount of a firm's debt is likely to be proportionate to its size, we adjust the variation of debt by the book value of the firm. The larger the variation of debt, the more likely that default will ensue.

Closely related to long term debt is the effect of long-term investment. We posit that a firm is likely to raise the level of its investment activity when its overall risk rises. That is to say, stockholders wary about default risk might accept investment projects they would otherwise decline in an effort to regain financial stability. This would be even more significant when the increase in investment is fueled with further debt, perhaps indicating that the firm is gambling with its future by using its bondholders' funds.

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* Contributed by -
Saurabh Joshi & R. T. Sivasubramaniyan,
PGDM - II Finance,
SCMHRD, Pune.